Moody’s downgrades Canadian banks: Beginning of the end for the housing market?

WATCH: In a rare move, the credit rating of Canada's biggest banks was downgraded a notch. As David Akin reports, it's not because there's a problem with the banks - it's because Canadians are racking up too much debt.

Toronto-Dominion Bank (TD), Bank of Montreal (BMO), Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada and Royal Bank of Canada had their ratings on two key metrics lowered by one notch, Moody’s announced.

“Continued growth in Canadian consumer debt and elevated housing prices leaves consumers, and Canadian banks, more vulnerable to downside risks facing the Canadian economy than in the past,” David Beattie, a senior vice president at Moody’s said in a statement.

The news comes as troubled mortgage lender Home Capital has sparked concern about whether Canada is about to experience its very own housing and debt crisis, some 10 years after the global financial crisis.

So, is Canada indeed headed for a housing bust? And what would that mean for the economy and most Canadians?

The housing market may have turned a corner

“It’s not like anything has changed” for Canadian banks, Mike Rizvanovic of Veritas Investment Research said about Moody’s downgrade.

There was no event in particular that triggered Moody’s decision. Rather, the credit rating agency issued a warning to the shareholders of Canada’s big banks about what could potentially happen if the economy were to experience a downturn, Rizvanovic added.

Moody’s noted that debt held by consumers and private businesses in Canada has ballooned to 185 per cent of GDP at the end of 2016, up from 179.3 per cent in 2015. That’s a lot of additional debt in a short period of time, and we don’t quite know how well household balance sheets would hold up in a serious recession, the agency noted.

The downgrade is a warning shot to Canada’s financial institutions but is unlikely to have a significant, direct impact on them, said Rizvanovic.

However, the move is the latest in a series of developments that signal that economists, politicians and the banks themselves are becoming more pessimistic about the housing market, said David Madani of Capital Economics.

Policymakers have been tightening the screws on the mortgage market — first in Vancouver, with the foreign homebuyers’ tax, then at the federal level with the new mortgage rules, and recently in Ontario, with the province’s own tax on foreign speculators. Some of Canada’s big banks have also become more vocal about risks in the mortgage market, with BMO and TD warning of a housing bubble in Toronto. Home Capital, Canada’s largest provider of riskier non-prime mortgages, has been experiencing a crisis of confidence among its clients and a run on deposits after regulators alleged it misled investors. And now we have Moody’s downgrade.

It all signals a shifting mood, said Madani, who has long been an outspoken skeptic of the Canadian housing market.

Unlike many of the analysts at Canada’s big banks, Madani believes that Canada’s real estate frenzy will necessarily end with some sharp drops in home prices.

“All bubbles burst, and we’ll have a major correction,” he said.

A major correction would see prices at the national level decrease by 30 to 40 per cent, he added. That’s the kind of drop required to bring prices back in line with income levels, he noted.

The drop, however, would likely happen over time and mostly reflect an adjustment in Canada’s red-hot markets of Toronto and Vancouver, Madani said, adding that “smaller markets would see no big declines.”

The fact that Canada’s financial landscape is dominated by a few big banks has also ensured that the market share for smaller lenders to pursue riskier mortgage borrowers has remained small, Rizvanovic added.

Even if home prices were to start heading south, “I’m not expecting a major upheaval in the banking sector,” he said.

A slowdown in the housing market could bring down GDP growth to around one per cent next year, compared to a forecast of two per cent growth this year, he told Global News.

Rizvanovic also noted that Canada’s banks fared relatively well during the downturn in Alberta and Saskatchewan.

Although the latest economic contraction, spurred by low oil prices, was more painful for the region than the one tied to the financial crisis, “it’s not like [Albertans] are walking away from their homes.”

WATCH:Ontario’s plan to fix out of control housing market

But if there was a recession, record-high household debt would make it worse

Still, both Madani and Rizvanovic told Global News that if Canada were to enter an economic downturn, current sky-high home prices and record levels of household debt would likely make it much more painful.

Overstretched household budgets mean that Canadians would likely have to pull back sharply on spending in the event of a job loss or reduced income growth. And the housing market has grown to account for such a large share of the economy that any contraction in the industry would have a significant impact on the wider economy, they told Global News.

New construction in Toronto alone accounts for one per cent of GDP, Madani estimates.

Stagnating or declining home prices would also weigh on consumer spending through what economists refer to as “the wealth effect,” both Madani and Rizvanovic said. People tend to feel wealthier and splurge when the price of their home is going up. But when house prices decline, that psychological effect works in reverse.

All of that could turn a recession “from bad to very bad,” said Madani.